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Berkshire Hathaway chief executive Warren Buffett characterized the company's 2012 performance as "subpar" in his eagerly awaited annual shareholder letter released late Friday. He was referring to Berkshire's 14.4% gain in book value during 2012, which trailed the Standard & Poor's 500 index's total return of 16%

Berkshire isn't the bargain that it was when Barron's last wrote favorably on the company last fall ("Buffett's Latest Bargain: Berkshire Hathaway", Nov. 12, 2012) when the stock traded around $127,000. Yet Berkshire probably is a good bet to outpace the S&P 500 index this year and top $160,000 a share. The shares now trade for more than 1.3 times year-end 2012 book value of $114,214, up from under 1.2 times book at the time of our November article.

Berkshire's annual profits hit $12.6 billion last year, up from $10.8 billion in 2011, thanks to another strong showing from the company's various insurance businesses and big divisions like the Burlington Northern railroad, which earned $3.4 billion after taxes. Buffett's 2009 purchase of Burlington Northern stands as one of Berkshire's best acquisitions ever with the company paying what turned out to be about 10 times last year's earnings for railroad.

Investment manager and Berkshire holder David Rolfe of Wedgewood Partners called the Buffett letter "a tour de force of Berkshire's competitive advantages and its world-class managers" in a note this weekend.

The company's virtuous cycle of strong operating profits begetting attractive investment opportunities was highlighted by Berkshire's recent deal to buy
Heinz
(HNZ) for $23 billion in conjunction with Brazil's 3G. Berkshire will invest $4 billion for half of the equity in Heinz and get $8 billion of attractive preferred stock paying 9% that will result in $720 million annually of tax-advantaged dividends. Berkshire's purchase of $5 billion of Bank of America preferred in 2011 was another coup because it came with free warrants on more than 700 million
Bank of America bac -0.8376288659793815%Bank of America Corp.U.S.: NYSEUSD15.39
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59902058AFTER HOURSUSD15.38
-0.00999999999999979-0.0649772579597141%
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P/E Ratio
42.75Market Cap
163276618878.357
Dividend Yield
1.299545159194282% Rev. per Employee
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common shares (BAC) now worth about $3 billion.

Wall Street seems to be focusing on Berkshire's attributes and earnings power rather than on Buffett's age -- he's 82 -- and the lack of a designated successor as CEO. The shares have risen smartly in recent months, including a 20% gain since our November article, double the gain in the S&P 500.

The annual letter was important because it offered a defense of Berkshire's refusal to pay a dividend and it also provided some clues to what Buffett considers to be the company's "intrinsic value."

Buffett wrote that if a company that can earn a consistent 12% return on its tangible net worth and trade for 125% of book value, it's better off retaining all its earnings for reinvestment than paying out, say, a third of its profits in dividends.

These two financial measures -- a 12% return on tangible net worth and a stock value of 125% of book -- closely resemble Berkshire. The better option for shareholders in the enterprise described by Buffett would be to sell a small amount of shares annually -- about 3%. That, not surprisingly, is what Buffett has done in recent years as he has sold 4.25% of his shares each year to fund various charitable contributions, most notably his gifts to the Bill and Melinda Gates Foundation.

Buffett again noted that book value is a "significantly understated proxy" for intrinsic value. He also described how Berkshire now is willing to pay up to 120% of book to repurchase shares. Buffett went on to say that companies should only buy back shares at a "meaningful discount to conservatively calculated intrinsic value." This suggests that Berkshire's share buybacks -- some $1.3 billion last year -- were done at a meaningful discount to intrinsic value. "It's hard to go wrong when you're buying dollar bills for 80 cents or less," he wrote.

Investor Rolfe interpreted this as Buffett telling investors that Berkshire is worth "a minimum " of 150% of book, or 120% of book divided by 0.8. "Professor Buffett has just revealed the secret sauce formula for calculating the intrinsic value of Berkshire Hathaway," Rolfe wrote over the weekend.

At 150% of book, Berkshire would trade at $171,000 based on year-end 2012 book. Book value could hit $118,000 by the end of March because earnings now are running at about $2,000 per class A share per quarter and Berkshire's $87 billion equity portfolio has appreciated in the quarter. Year-end 2013 book could top $125,000, meaning that the shares could finish this year at $162,500 if they command 1.3 times book or $187,500 if they hit 1.5 times book.

That's not bad appreciation potential from current levels. Downside in the share price seems limited. Why? Book value is steadily rising and Berkshire's willingness to pay 120% of book for its shares should help put a floor under the stock.

One risk is a sharp drop in the equity market that would dent the equity portfolio. Berkshire has massive cash reserves that likely will total about $30 billion even after the Heinz deal closes later this year. This gives the company the wherewithal to make another big acquisition or repurchase stock. It's no wonder that Buffett has said he "tap dances" to work each day.